Loan creates deposit. Reserve rule + leakage + capital decide how far it goes. Click-to-reveal explainers and a hands-on game.
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TL;DR — How Money Is Created & Why M1 ≠ MB
Loans create deposits. Deposits count in M1, so M1 can be many times larger than MB (currency + reserves). Each round banks keep a fraction as reserves and lend the rest → redeposit → repeat (a multiplier builds deposits).
Limits: required + excess reserves, currency drain (people hold cash), and capital constraints (equity/assets).
Reality today (useful facts for FIN310):
U.S.: formal reserve requirement is 0% since March 2020. Banks still hold reserves by choice for payments/liquidity and because reserves may earn interest.
Euro area: minimum reserve is about 1% of certain liabilities (cut from 2% in 2012). We use 20% only as a classroom example to show a small toy multiplier (≈5×) before leakages/capital.
FAQ (plain words)
Why is money supply bigger than what’s injected? Because commercial banks create deposits when they lend. Base money is the seed; lending multiplies deposits until frictions stop it.
What “fractional reserve” do banks actually use? There isn’t one number today. Formal minima (U.S. 0%, euro ≈1%) often don’t bind; liquidity and capital rules + risk appetite and loan demand do.
Why hold excess reserves? Payments safety, liquidity metrics (LCR/NSFR intuition), interest on reserves (if paid), collateral/ops, and conservatism.
History of Reserve Requirements
Pre-2020 U.S.: tiered rr; top tier 10% on large transaction deposits — the number many remember.
March 2020 U.S.: rr set to 0% across the board. Banks still hold reserves voluntarily; regime operates with ample reserves.
Euro area: rr ≈ 1% (cut from 2% in 2012).
Why this matters
If rr=0, what’s “fractional” now? Lending is mainly constrained by capital ratios and liquidity rules, not a fixed rr. The game below lets you flip between the old 10% rule and modern 0% to see the difference instantly.
Capital & Liquidity Rules — Plain English (with fractional rr)
Why this matters: Even if the required reserve ratio (rr) is low or 0%, banks can’t lend without limit. Two other sets of rules bite: capital ratios (can you absorb losses?) and liquidity rules (can you meet cash outflows?).
1) Capital ratios (loss-absorbing capacity)
CET1 ratio (core capital):Common equity / Risk-weighted assets. If this falls too low (minimum + buffers), the bank must slow/stop balance-sheet growth (new loans) or raise equity.
Leverage ratio (backstop):Equity / Total assets (no risk weights). Prevents too much leverage even if assets look “low-risk.”
In our game:Capital Min % is a toy version of these rules. We compute capital% = Equity / Assets with Assets = Reserves + Loans. If capital% drops below your minimum, lending stops—even if rr is small.
2) Liquidity rules (can you pay people on time?)
LCR (Liquidity Coverage Ratio): hold enough High-Quality Liquid Assets (HQLA: reserves, Treasuries, etc.) to cover projected 30-day net cash outflows (target ≥100%).
NSFR (Net Stable Funding Ratio): ensure stable funding over a 1-year horizon: Available stable funding / Required stable funding ≥ 100%.
Link to fractional rr: Even when rr is 0% or small, banks still hold extra liquid assets (often reserves/Treasuries) to satisfy LCR/NSFR and to make payments smoothly. This is why we talk about excess reserves in modern systems.
How these interact with rr (simple)
Constraint
What it asks
What “counts”
When it stops lending
Reserve requirement (rr)
Keep a fraction of deposits as reserves
Central-bank reserves, vault cash
When you don’t have enough reserves vs. deposits
Capital ratios
Keep enough equity vs. assets (loss buffer)
Common equity, retained earnings
When Equity / Assets (or risk-weighted) would fall below minimum
Liquidity rules (LCR/NSFR)
Hold liquid assets & stable funding
HQLA (reserves, Treasuries); stable funding
When adding loans would leave too little HQLA or stable funding
Where this shows up in the game
Capital Min % → toy capital constraint. As loans + reserves (assets) grow while equity stays fixed, the ratio falls and can bind.
Currency Drain % → mimics cash leaving banks (outflows), which makes redeposits smaller—think of it as a simple liquidity friction that shrinks the multiplier.
If you want to mimic liquidity buffers, choose a higher rr to represent banks voluntarily holding more liquid assets than required (excess reserves).
Intro
Fractional reserve banking lets banks create deposit money on top of the monetary base. The process stops when reserves, cash leakages, or capital requirements bind.
Engine vs Brakes — Modern View
Engine: Fractional reserve is still a great mental model for how loans create deposits. A new loan credits a deposit; deposits keep cycling until leakages, reserves, or capital stop it.
Brakes today: Even with rr = 0%, growth slows because of:
Capital ratios: CET1 & leverage rules force banks to hold enough equity vs. assets. If Equity/Assets is too low, lending stops.
Liquidity rules: LCR & NSFR require banks to hold HQLA and stable funding; too many loans without funding breaks the rule.
Behavior: risk appetite, loan demand, supervisory guidance, and profit motives all shape lending.
Key takeaway for FIN310:Fractional reserve banking is not useless — it explains the money creation engine. But the binding brake is usually capital/liquidity today, not a fixed rr. Use the game to see which brake engages first.
Step-by-Step Story
Deposit $1,000 → bank must keep rr% as reserves.
Bank lends the rest → borrower spends → seller deposits → next bank repeats.
With no leakages/constraints, total deposits approach initial/rr; loans ≈ initial(1−rr)/rr.
Link to M1 vs MB
Each round’s deposits add to M1; the reserves slice sits in MB. Higher reserves/leakage or tighter capital ⇒ smaller gap between M1 and MB.
Interactive Game — Build the Multiplier
Growth (loans → new deposits)
Reserves kept (can't lend)
Leakage (cash leaves banks)
How this game works
We start from the latest new deposit. The bank keeps a fraction as reserves and lends the rest.
Some of that loan becomes cash (leak) and doesn’t redeposit; the remainder is redeposited to fuel the next round.
As assets grow, capital ratio = equity / assets falls. If it dips below your minimum, lending stops.
The geometric process naturally fades even without capital binding.
Reality check: mapping rules to the toy
This simulator is a teaching toy. Capital Min % ≈ capital/leverage constraint; Required Reserve % ≈ rr (you can also use it to mimic voluntary liquidity buffers); Currency Drain % ≈ cash outflows that reduce redeposits. In real life, banks manage all three together.
Settings
Capital in this toy
Assets = Reserves + Loans. Equity is fixed initially. As assets grow, Equity/Assets falls. If it drops below your minimum, the game stops.
Your Prediction
Hint (toy): r* = (rr + er + cd − rr·cd/100)/100 ⇒ deposits ≈ initial / r* (if capital doesn’t bind).
Round 0 / 10
Quick presets:
Controls
Status:
Round-by-Round Table
#
New Loan
Reserves Kept
Cash Leak
New Deposit
Cum Deposits
Cum Loans
Reserves
Assets
Capital %
Final Deposits:
Final Loans:
Final Capital Ratio:
Score:
Round-by-Round Explanation
What the colors mean
Green fuels next round; Amber reserves kept (MB); Red cash leak (no redeposit).
Results Explainer
Math used here
Effective reserve fraction f = rr + er (as %) → f/100 of each new deposit kept as reserves.
Currency drain c = cd% of each new loan leaves as cash (not redeposited).
Q1. With rr=10% and no leakage, deposits eventually approach:
Q2. A higher currency-drain % mainly:
Q3. Even if reserves are ample, lending can stop because:
Homework — Fractional Reserve Lab (250–400 words)
Set (rr, er, cd, capMin, equity) and start with $1,000 deposit. Record your prediction and final results.
Run three scenarios: (A) rr=0, cd=0; (B) rr=10, cd=10; (C) rr=5, cd=10, capMin=8 with equity $80.
Explain which constraint binds in each case and how it changes deposits and loans.
Conclusion
Takeaway: Loans create deposits, so money supply can grow far beyond base money. Historically the U.S. often used a top-tier 10% rr; today rr=0% (Euro ≈1%), so capital/liquidity and behavior are the main brakes. The 20% example is just a teaching tool to show a small multiplier (≈5×) clearly.
Note: Game math is simplified for classroom intuition; not a regulatory model. Reserve rules vary by country/time; banks also face capital/liquidity requirements and behavioral constraints.